Chapter 17 management of accounts receivable and inventory
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Chapter 17 Management of Accounts Receivable and Inventory Receivables Management For a firm to grant credit to its customers: Establish Credit and Collection Policies Evaluate Individual Credit Applications Credit Management as a Career Accounts Receivable A/R

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Chapter 17 management of accounts receivable and inventory l.jpg
Chapter 17Management of Accounts Receivable and Inventory

Finance 312

Receivables management l.jpg
Receivables Management

  • For a firm to grant credit to its customers:

    • Establish Credit and Collection Policies

    • Evaluate Individual Credit Applications

  • Credit Management as a Career

Finance 312

Accounts receivable a r l.jpg
Accounts Receivable A/R

  • Large investment for most companies

  • Essentially an investment decision

  • Extend credit whenever the marginal returns from extending credit exceed the marginal costs

  • Liberal credit policy provides returns in the form of increased sales and gross profit, but...

  • Costs

    Cost of funds Costs of credit checking Collection costs Increase in bad debts

  • Trade credit/ Consumer credit

Finance 312

Credit policy l.jpg
Credit Policy

  • Credit standards

    • Criteria used to screen credit applications

    • Controls the quality of accounts

  • Credit terms

    • Conditions under which credit extended must be repaid (including discounts)

    • Use of Electronic Data Interchange (EDI)

  • Collection efforts

    • Methods employed in an attempt to collect payment on past due accounts

    • Think of the picture “Rocky I”

  • Credit line

Finance 312

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Credit Standards

  • Quality

    • Time a customer takes to repay

    • Probability a customer will fail to repay

      • Default risk - Dun & Bradstreet Rating

  • Measures of quality

    • Average collection period

    • Bad-debt ratio

  • Balance between too lenient and too strict

    • Too restrictive a policy - lost sales and profits

    • Too lenient a policy - Higher investigation costs, Bad debt losses, collection costs, high investment in A/R

Finance 312

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Net Change in Pretax profits Associated With Granting Credit

  • Marginal profitability of additional sales = Profit contribution ratio X Additional sales

  • Additional investment =

    Additional ave daily sales X Ave collection period

  • Cost of additional investment in A/R = Additional investment in A/R X Pretax required return

  • Additional bad-debt loss = Bad- debt loss ratio X Additional sales

  • Additional collection expenses

  • Cost of additional investment in inventory = Additional inventory X Pretax required return

  • Net change in pretax profits = Marginal returns - Marginal costs

Finance 312

Credit terms l.jpg
Credit Terms

  • Credit period

    • Time allowed for payment

      • e.g. 30 days

  • Cash discount

    • Allowed if payment is made within a specific period of time

    • Specified as % of the invoiced amount

    • Granted to speed up collection of A/R

    • e.g. 2/10, n/30; 2/10 EOM, n/30

    • Kinked demand curve if oligolopistic competition exists and everyone changes their terms.

Finance 312

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Credit Terms (Concluded)

  • Seasonal dating (Not a “Social Event”)

    • Offered to retailers on seasonal merchandise

    • Accept delivery well ahead of peak season

    • Pay shortly after peak sales

      • Advantages

        • Promotes sales - goods are on hand

        • Reduces manufacturing inventories

        • Allows producers to smooth production and distribution

        • Assists retailers in financing inventory

        • e.g. O.M. Scott

Finance 312

Collection efforts l.jpg
Collection Efforts

  • Methods employed to attempt to collect payments on past due accounts

    • Letters

    • Telephone Calls

    • Personal Visits

    • Collection Agencies

    • Legal Proceedings

  • Balance between leniency and alienating customers

Finance 312

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Collection Efforts (Concluded)

  • Monitoring status

    • Average Collection Period

    • Aging of Accounts Analysis

      • Classifying accounts into categories according to the number of days they are past due

      • Changes in the age composition of accounts may reveal changes in the quality of A/R

    • Both methods are affected by fluctuations in sales

Finance 312

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Analysis of a Change in Credit Policy

  • Increase in the credit period

    • Increase the quantity of goods sold

    • Increase in profits

    • Cost increases from additional investment in A/R, collection costs, bad debt costs

  • Liberalization of cash discount

    • Increase in sales & pretax profit contribution

    • Reduction in A/R balance

      • Additional income from alternative investments

      • Decrease in cost of funds

      • Reduction in cash revenue

Finance 312

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Analysis of a Change in Credit Policy (Concluded)

  • Increase in collection effort

    • Reduced sales and pretax profit contribution

    • Increased collection expenses

    • Possible reduced bad-debt losses

  • Size of Credit Line

    • Limits are not as enforced as rejection

    • How large a line?

Finance 312

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Evaluation of Credit Applications

  • Gathering information

    • Experience with customer

    • Credit reporting agencies - e. g. Equifax

    • Banks

    • Financial statements submitted by applicant

    • Personal visits

  • How much does the analysis cost ?

    • Begin with the least costly and time consuming source

    • Is it worth it to proceed further?

Finance 312

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Evaluation of Credit Applications (Concluded)

  • Numerical scoring system

    • Multiple Discriminant Analysis (MDA)

    • Expert systems

  • Six C’s of credit

    • Character

    • Capacity

    • Capital

    • Collateral

    • Conditions

    • Country

Finance 312

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Inventory ( INV )

  • Buffer in the procurement-production-sales cycle

  • Role of Electronic Data Interchange (EDI)

  • Flexibility

    • Timing the purchase of raw materials

    • Scheduling production facilities & employees

    • Meeting fluctuating & uncertain demand

  • Investment of funds

  • Benefits & costs of holding inventory

  • Collaborative Forecasting And Replenishment

    • Parties exchange data electronically(such as details of future sales promotions, analysis of sales trends)

Finance 312

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Types of Inventory

  • Raw materials inventory

    • Stores of items used in production

    • Quantity discounts

    • Assure supply in times of scarcity

  • Work-in-process inventory

    • Items at some intermediate state of completion

    • Allows for asynchronous schedules

    • Size related to length and complexity of production cycle

  • Finished goods inventory

    • Items ready and available for sale

    • Permits prompt filling of orders

    • Economies of scale

Finance 312

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Costs Associated with an Inventory Policy

  • Ordering costs

    • Costs of placing and receiving an order of goods

  • Carrying costs

    • Costs of holding inventory for a given period of time

    • Expressed as

      • Cost per unit per period

      • A % of the inventory value per period (e.g. 20%)

  • Stockout costs

    • Incurred when a firm is unable to fill an order

    • Involves:

      • Lost sales

      • Rescheduling production

      • Placing and expediting special orders

Finance 312

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Inventory Control Models

  • ABC Inventory Classification

  • Basic EOQ Model

    • Deterministic Model

    • Assumes:

      • Annual demand or usage is known with certainty

      • Usage is constant - no seasonality

      • Orders to replenish are instantaneously filled

      • No need for safety stocks

Finance 312

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EOQ ( Q* )

  • Total costs = Ordering costs + Carrying costs

  • Total costs = ( # of orders per year X Cost per order ) +

    ( Ave INV X annual carrying cost per unit )

  • Total costs = ( D/ Q X S ) + ( Q/ 2 X C )

  • Q* = 2SD / C

  • T* =


365 X Q*


D /365


Finance 312

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Inventory Control Models (Concluded)

  • Reorder Point

    • Defined as the inventory level at which an order should be placed for replenishment of an item

  • Extensions of Basic EOQ Model

    • Nonzero lead time

    • Probabilistic inventory control methods

  • Just-in-time inventory systems


= X D


Finance 312

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  • Receivables Management

    • Credit Policy

      • Credit Standards

      • Credit Terms

      • Collection Efforts

      • Credit Line

    • Evaluation of Credit Application

  • Inventory Management

    • Inventory costs

    • EOQ

Finance 312